SINGAPORE/KUALA LUMPUR (Reuters) - Malaysia's normally tranquil currency and bond markets have been whipsawed by an exodus of foreign capital as investors reassess emerging markets most at risk from a withdrawal of U.S. easy money policy, heightening the possibility of a vicious sell-off that could hurt the economy.
The ringgit currency is at three-year lows against the dollar and month-long selling has pushed 10-year Malaysian government bond yields to their highest in 2-1/2 years.
Economic growth is slowing, the country's typically large trade surplus has nearly disappeared and the government has been dragging its feet on much-needed reforms to fix a large fiscal deficit - all giving foreign investors reason to re-evaluate their exposure to the Southeast Asian country.
But a bigger worry for them has been talk that regular bulk domestic buyers of Malaysian bonds, the state pension fund and banks included, are purchasing less. That has led to heavier selling than analysts think is justified by the economic risks.
"The buyer of last resort is less evident," said Claudio Piron, strategist at Bank of America Merrill Lynch.
As of May, foreigners held nearly 50 percent of outstanding government bonds, the Employees Provident Fund (EPF) a little more than 30 percent and the rest by local banks and insurers.
The latest central bank data shows foreign holdings slipped to 137.88 billion ringgit ($42.5 billion) in June from 144.5 billion ringgit in May.
Falling bond yields and the pressure to improve returns have compelled banks to divert investments into corporate bonds and longer-term Islamic finance products, analysts said.
The EPF hasn't explicitly said it will slow its bond purchases. But 55 percent of its investments are in bonds and it has said it wants to expand its foreign portfolio in search of higher yields. Sources told Reuters last week the EPF is investing in German and French properties.
It is little surprise then that a redemption of 9.2 billion ringgit of local government bonds this week unnerved foreigners, exaggerating fears about the economy even though it far more resilient to capital flows than peers such as Indonesia, India, Thailand or South Korea.
Fitch Ratings added to those worries on Tuesday, placing Malaysia's A minus rating on negative outlook, citing weak prospects for reforms to fix public finances.
So far, the selloff in Malaysia stops short of being termed turmoil. The ringgit has fallen 6.6 percent since May 22, when the Fed first raised the spectre of early stimulus withdrawal, less than the Indian rupee's 8.5 percent drop.
The stock market is down 2 percent in the past week, only a fraction of the 33 percent gains in two years.
The risk is that the falling currency and the spotlight on the shrinking current account surplus will push Malaysia into a vicious feedback loop of capital outflows and plunging markets.
"It's a slippery slope," said Piron.
"But the issue of whether Malaysia becomes an India or Indonesia is when the outflows jeopardise the fundamental picture and the fundamental picture jeopardises the flows picture. Then it becomes more serious."
WAITING FOR POLICY RESPONSE
For emerging market investors positioning for tighter Federal Reserve policy, the possibility that the current account surplus will vanish this year puts Malaysia in the same basket as India, Indonesia and Thailand - economies that are highly vulnerable to sudden shifts in foreign capital.
That was a point Fitch made, although the delay in measures to fix government debt that is close to hitting a constitutional ceiling of 55 percent of gross domestic product (GDP) was the primary reason for the negative outlook on ratings.
A failure to contain spending will render it impossible for the government to bring its budget deficit down to a targeted 3 percent of GDP by 2015, from 4.5 percent in 2012.
The primary means for doing that would be through a general sales tax and a reduction of heavy subsidies on fuel.
But Prime Minister Najib Razak must safely negotiate internal party elections on October 5 to solidify his position before he can attempt to take any such unpopular measures. His position is weak after his Barisan Nasional coalition scraped through with a depleted majority in the general election in May.
Markets appear sceptical about prospects for reform. The ringgit firmed only briefly before retreating on Thursday after Najib said his government was committed to improving the fiscal position and would announce steps to do so in October.
Meanwhile, plunging prices of Malaysia' palm oil exports and rising copper imports have hurt the trade balance, although analysts expect the current account will still show a marginal surplus in 2013.
Ten-year bond yields have risen more than a 100 basis points, crossing 4 percent for the first time since early 2011, but yields were above 5 percent in 2008, before global central banks embarked on pump-priming crisis measures.
HSBC data shows foreigners pumped $9.3 billion into Malaysian bonds in 2012, and $5 billion until May this year.
"There's so much pretty mobile money that has poured in and can pour out," said Gerald Ambrose, managing director at Aberdeen Asset Management in Kuala Lumpur.
"By that token, the exodus of all this money can be a problem. It can be self-fulfilling."
(Additional reporting by Stuart Grudgings in Kuala Lumpur; Editing by Kim Coghill)